“Tomorrow’s Advance Man” is a New Yorker story (May 18, 2015 issue) about the world of Marc Andreessen, NCSA Mosaic browser programmer turned venture capitalist.
The story explains how the top firms get consistently better returns than the less-known ones: “The imprimatur of a top firm’s investment is so powerful that entrepreneurs routinely accept a twenty-five per cent lower valuation to get it.” (i.e., they are buying at a lower price than competitors)
The market-clearing price for a competent venture capital partner is not very high: “[A16z] general partners make about three hundred thousand dollars a year, far less than the industry standard of at least a million dollars, and the savings pays for sixty-five specialists in executive talent, tech talent, market development, corporate development, and marketing.” Presumably the partners get some kind of boost when a portfolio company is sold, but $300,000 per year is what a senior programmer at Apple or Google could expect to earn (and more evidence that Ellen Pao would have made more money by getting pregnant than by working as a VC).
What would be a fair price for the job? Maybe $0:
The dirty secret of the trade is that the bottom three-quarters of venture firms didn’t beat the Nasdaq for the past five years. In a stinging 2012 report, the L.P. Diane Mulcahy calculated, “Since 1997, less cash has been returned to V.C. investors than they have invested.” The truth is that most V.C.s subsist entirely on fees, which they compound by raising a new fund every three years. Returns are kept hidden by nondisclosure agreements, and so V.C.s routinely overstate them, both to encourage investment and to attract entrepreneurs. “You can’t find a venture fund anywhere that’s not in the top quartile,” one L.P. said sardonically. V.C.s also logo shop, buying into late rounds of hot companies at high prices so they can list them on their portfolio page.
“The truth is that most V.C.s subsist entirely on fees, which they compound by raising a new fund every three years.”
Would someone mind explaining what this means? Who pays the fee? And how does raising a new fund help?
Mark — here’s how the math of this works. A VC fund raises, say, $300M. A little of the cash in the fund might come from the VC partners, but the majority will come from an institution, such as a pension fund. The fund makes a set of investments over the course of its first few years, and then basically stops making new investments once the money is more or less spent. Each year, the fund pays its managers a 2% fee (so, $6M / year). When and if an investment is sold for a profit, the managers take 20% of the realized profits (subject to offsetting losses for investments which are ultimately written to zero). So if our fund starts with 300M, and five years hence manages to sell its various investments off for 600M, the managers will pay themselves $30M in management fees (2% / year * 5 years), 48M in incentive fees (of the remaining 240M in profits, 20%), for a net payout of 78M. The investors get 228M on a 300M initial investment, which will work out to a 12% annualized rate of return.
One thing to note about the ‘new fund every 3 years’ comment: most of these funds make investments in very early stages in companies, and don’t get to sell their early stake out for many years. It is typical to not realize any profits at all for, say, 5+ years. As various companies have fundraising rounds at ever-higher valuations, one year in the VC can say: ‘marked to the most recent round of valuations, we’re up 50%!’. In reality, these are totally unrealized gains. But if they raise a second fund three years after their first fund is up 100% (on paper), presumably they caise 3B the second time around, and subsist on locked-in fees for quite a while.
Note that my previous example — a 12% CAGR — is wildly optimistic.
It is not fair compare average VC return for period 1997 – 2012, that includes 1997-1999 IPO bubble fueled by large underwriters and not VCs alone and low stock market valuations of 2012. My guess that inflation adjusted investments for the same period in any managed funds would not be great either.
Saying that I know next nothing about VC and VC / underwriters relationships. At least on the face of it VCs are using capital to create new value.
Thanks, Patrick!